Is Venture Capital an Academic Pursuit?

The tech VC meltdown is already laying waste to smaller firms and those who entered the game too late. Even the best scenarios are unlikely to generate returns commensurate with the investment risk and lack of liquidity. Where will new capital come from? It is likely that a new player in traditional corporate venture capital will grow in importance: university-funded commercialization.

By Andrea Belz
07/12/10 5:00 AM PT

Venture capitalists style themselves as the stewards of entrepreneurship, offering cash (and supposedly expertise) to young Edisons seeking both fame and fortune. Stunning returns for early investments in companies like Google (reportedly each dollar invested returned US$10,000) kept the dream alive for egocentric investors and entrepreneurs alike.

And yet like a Greek tragedy, the halcyon days brought the seeds of destruction. One recent analysis by Harvard Business School Professor William Sahlman demonstrated that median returns peaked in 1996 at 45 percent, and by 2008, those returns were -10 percent. Technology definitely lost its luster; last year, Cambridge Associates reported that returns in the electronics industry decreased from 157 percent on companies founded in 1998 to 5 percent for those founded in 1999; they have been negative for all subsequent vintage years. 1998 was clearly a banner year: Returns on hardware companies founded then reached 150 percent and have oscillated between -13 percent to +30 percent in the subsequent years, while 1998-vintage information technology companies generated astonishing IRRs of 275 percent and have been consistently less than 30 percent for all vintage years since then. (Observant readers will remember that Google was the crown jewel of the "entering class" of 1998.) It wasn't a bubble; it was a nuclear mushroom cloud.

Late to the Game

The lower returns stem from the high fatalities in the VC industry's train wreck. Sahlman's Harvard-based study showed that most of the capital is lost completely; 62 percent of 600 analyzed investments were lost, while 3 percent accounted for 53 percent of the profit. This month's Harvard Business Review reports that reduced exits (17 IPOs per week in 2000, compared to 15 in 2008 and 2009 combined) and longer waits are taking their toll. HBR's estimate that the industry will shrink by half was already demonstrated in a 2009 PricewaterhouseCoopers report that between 2007 and 2009, the capital pool had been reduced by half to levels last seen 10 years ago. The purge is likely to continue.

Large firms able to set the terms on infinite numbers of follow-on funding rounds will survive the industry meltdown, but newly minted professional investors who got into the act too late (1999 or 2000) are now coming to terms with the lack of return to their investors. Small and mid-sized firms waiting for exits are now forced to extend the funds past their anticipated terms, sharing their own life support with that of their portfolio companies. Even the best of scenarios (and many firms have been known to describe their outlandish scenarios as "conservative") is unlikely to generate returns commensurate with the investment risk and lack of liquidity.

Where will new capital come from? It is likely that a new player in traditional corporate venture capital will grow in importance: university-funded commercialization. Recently The New York Timesreported how schools including the University of Utah, the University of Virginia and Carnegie Mellon are intensifying their technology transfer efforts. And they are starting to put their money where their proverbial mouth is.

Consider New York University announcing its new $20 million venture fund to commercialize internal research. While powerhouses like MIT, Stanford and Caltech have long provided infrastructure to nurture new companies, the next tier of schools wants to get into the action.

The math of the funding needs for a portfolio of 10 companies suggests that they need to reach about $60 million in size; at that point, a university can keep up with the follow-on investments required to bring the successes to maturity. Funds of $15-20 million in size are nice to test the concept with faculty but will make it difficult to provide real returns.

Groking Market Research and Dynamics

However, it will be easier to reach organizational goals such as attracting and retaining faculty members without the extraordinary returns of the large venture funds, and it should be possible to reach internal hurdle rates of return to satisfy the Board of Trustees and other stakeholders. The key risk -- and it is a significant disadvantage -- is the lack of understanding of market research and dynamics as these groups try to push their technologies into an unwilling marketplace. On the other hand, a university reaching internally for funds instead of to a state pension plan will have extra tolerance for a steep learning curve.

Imagine a finance market where university professors go to internal sources of funds instead of external venture capital. The professor is happy because he has institutional support and can minimize his time dedicated to dog-and-pony shows. University administrators can retain good faculty members with the promise of funding future enterprises. Technology development risk can be addressed and partially retired in focused development prior to funding by larger venture capital funds and strategic investors, making the new investors happy. And as I reported in my last column, American universities still represent a strong innovation engine on an international basis.

Make no mistake: Traditional venture capital isn't falling apart, it's already collapsed. Mid-tier funds founded in the heyday and lacking a payday will be forced to exit the arena as pension plans and institutional investors regroup. Meanwhile, university administrators will take advantage of the vacuum to create a new avenue of financial support for their innovators. Expect to see more universities participate directly in early-stage investing in technology in the next few years as they pick up the mess after the venture capital party of the last decade.